How to overcome 2 & 20...no this isn't about football.

Here's a great article I read recently that shares my view on hedge funds.  Remember, things are not always what they seem...

Why I won’t invest in hedge funds

Commentary: As in Vegas, the percentages are never in your favor

By Brett Arends, MarketWatch

LAS VEGAS (MarketWatch) — The rich and powerful of the hedge-fund world flew in here last week for a big confab.  Nearly 2,000 managers, investors, advisers and hangers-on took over the Bellagio for three days. George W. Bush stopped by. So did Colin Powell, TV historian Niall Ferguson, SAC billionaire Steve A. Cohen, and former British prime minister Gordon Brown.I didn’t make the poolside party on the first night, but it must have been quite an event. People looked pretty wobbly the next morning.

For all the big-name plenary sessions in the grand ballroom, the real action took place in side rooms, where investors and money managers talked dollars. Investors came in droves to meet new funds and try to find the manager who’s going to make them rich.  I wish them luck. But as I mingled with the money mavens, I did some thinking.

Your typical (hedge) fund manager takes 2% of your money off the top each year, just for showing up. Then he takes 20% of your profits — if any.  So your returns are going to be net of these costs. They’re also net of any trading costs. To beat a basic index fund, a hedge fund has got to earn a lot more.

How much more? Do the math. According to data from the New York University’s Stern school of business, over the past 80 or so years U.S. stocks have produced an average annualized return of 9.3%, and bonds 5%. So a portfolio of, say, two-thirds stocks, one-third bonds, would have earned an average return of about 7.9% a year.

Over an investment horizon of about 30 years, that’s enough to turn an initial stake of $1,000 into $9,800. But after 2%-and-20% fees, you’d only keep 4.7% a year (It would probably be even less, because profits are uneven, and in a down year the manager doesn’t hand back 20% of the losses).

At that rate, you’d only finish with $4,000. In other words, the manager would have eaten two-thirds of your profits!

But that’s not a fair comparison, say the fund managers, because we’ll earn a higher investment return than the market. OK, some will. But how much more? If the market on its own earns 7.9% a year, a hedge fund with a 2%-and-20% fee structure has to earn 11.85%, gross, just to keep up.  In other words it has to earn 50% more than the market each year. How likely is that? In these days of lower nominal returns, the challenge is even greater. And how much more do hedge funds really earn anyway? Some studies in the past have put the figure as high as 3% to 5% a year. But research just published in the Journal of Financial Economics blows this out of the water.

Professor Ilia Dichev at Emory University and Gwen Yu at Harvard Business School studied investors’ returns for nearly 11,000 hedge funds over 28 years, from 1980 to 2008.  Their main finding: Actual “dollar-weighted returns” — in other words, what investors really earned — were far lower than previously thought. That’s because we only tend to hear about the funds that do well. And because investors typically jumped into the good funds just after they had done well (and got out again after they had done badly).

Over the entire period, they found, hedge funds appeared to earn an average return of 12.6% a year. But investors really only made about 6%. That, they note, was a lot less even than the 10.9% you could have earned in the Standard & Poor’s 500 stock index over the same period. Indeed it wasn’t that much more than the 5.6% your grandma earned in U.S. government bonds. They also found that the volatility of returns was greater.

In other words, hedge-fund outperformance was largely a myth. And “the risk-return trade-off for hedge fund investors is much worse than previously thought,” they say.

And here’s a final thought from Sin City.

If a benchmark portfolio earns a typical 7.9% a year, then a hedge fund manager charging 2%-and-20% basically skims 3.2% of your money each year. As I listened to George Bush wow the audience, it occurred to me that the casino just down the corridor only took 2.7% on the spin of a roulette wheel. And if you played craps or blackjack, the house’s take is under 1%.  Next year, the Vegas casino operators should hold their annual conference in Greenwich, Conn., the house of the hedge funds. They could learn a thing or two from these guys.

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